Econ 204 week 9 outline

Prepared By Brock Williams
Chapter 10
Monopoly and
Price
Discrimination
On college campuses across the
country, beverage companies
like Coca Cola and Pepsi pay
cash in exchange for monopoly
power--exclusive rights to sell
beverages on campus.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 10-2
Learning Objectives
1. Describe and explain a monopolist's output
decision
2. Explain why a monopoly is socially
inefficient
3. Identify the tradeoffs associated with a
patent
4. Describe the practice of price discrimination

● monopoly
A market in which a single firm sells a
product that does not have any close
substitutes.
● market power
The ability of a firm to affect the price
of its product.
● barrier to entry
Something that prevents firms from
entering a profitable market.
Monopoly and Price Discrimination

● patent
The exclusive right to sell a new good
for some period of time.
● network externalities
The value of a product to a consumer
increases with the number of other
consumers who use it.
● natural monopoly
A market in which the economies of
scale in production are so large that
only a single large firm can earn a profit.
Monopoly and Price Discrimination

Total Revenue and Marginal Revenue
FIGURE 10.1
The Demand Curve and the Marginal-Revenue
Curve
Marginal revenue equals the price for the first unit
sold, but is less than the price for additional units
sold. To sell an additional unit, the firm cuts the
price and receives less revenue on the units that
could have been sold at the higher price.
The marginal revenue is positive for the first four
units, and negative for larger quantities.
10.1 THE MONOPOLIST’S OUTPUT
DECISION

A Formula for Marginal Revenue
marginal revenue = new price + (slope of demand curve × old quantity)
• The first part of the formula is the good news, the money received for
the extra unit sold.
• The second part is the bad news from selling one more unit, the
revenue lost by cutting the price for the original customers.
• The revenue change equals the price change required to sell one more
unit—the slope of the demand curve, which is a negative number—
times the number of original customers who get a price cut.
DECISION (cont.)

Using the Marginal Principle
A monopolist can use the marginal principle to decide how
much output to produce.
M A R G I N A L P R I N C I P L E
Increase the level of an activity as long as its marginal benefit exceeds its
marginal cost. Choose the level at which the marginal benefit equals the
marginal cost.
DECISION (cont.)

 FIGURE 10.2
The Monopolist Picks a Quantity and
a Price
To maximize profit, the monopolist picks
point a, where marginal revenue equals
marginal cost.
The monopolist produces 900 doses per
hour at a price of $15 (point b).
The average cost is $8 (point c), so the
profit per dose is $7 (equal to the $15
price minus the $8 average cost) and the
total profit is $6,300 (equal to $7 per
dose times 900 doses).
The profit is shown by the shaded
rectangle.
DECISION (cont.)

The three-step process explaining how a monopolist picks a
quantity and how to compute the monopoly profit is as
follows:
1 Find the quantity that satisfies the marginal principle, that
is, the quantity at which marginal revenue equals marginal
cost.
2 Using the demand curve, find the price associated with the
monopolist’s chosen quantity.
3 Compute the monopolist’s profit. The profit per unit sold
equals the price minus the average cost, and the total
profit equals the profit per unit times the number of units
sold.
DECISION (cont.)

• We expect the owner of a major-league baseball team to choose the quantity (the number of
fans at the game) at which MR = MC. The marginal cost of an additional fan is close to zero,
so the profit-maximization rule simplifies to MR = 0. And yet for the typical team, it appears
that MR is actually negative: adding fans by selling more tickets actually decreases total
revenue from tickets. What explains this puzzling behavior?
• We can illustrate the puzzle with a simple example. Suppose that with a ticket price of $24,
the team sells 20,000 tickets. If the slope of the demand curve is -0.002, marginal revenue is -
$16: MR = $24 - 0.002 x 20,000 = -$16. In this case, cutting the price to sell one more ticket
generates good news ($24 collected from the new fan) that is less than the bad news (the $40
lost on the 20,000 fans who would have paid the higher price). The marginal revenue is
negative, so the team could increase its total revenue from tickets by increasing the price and
decreasing the quantity of tickets sold. Why don’t MLB teams increase their ticket prices?
• The solution to this puzzle is concessions. Suppose the average MLB fan spends $20 per
game on merchandise that costs the owner about $4 to provide. In this case, each ticket sold
generates an additional $16 in net concession revenue to the owner, just enough to offset the
$16 revenue loss on ticket sales. Once we expand the definition of marginal revenue to
include the net revenue from concessions, the owner’s choice is consistent with the profit-
maximization. What appears to be too low a price could be just about right.
MARGINAL REVENUE FROM A BASEBALL FAN
APPLYING THE CONCEPTS #1: How does a monopolist
maximize profit?
A P P L I C A T I O N 1

Deadweight Loss from Monopoly
 FIGURE 10.3
Monopoly versus Perfect Competition: Its Effect on Price and Quantity
(A) The monopolist picks the quantity at which the long-run marginal cost equals marginal revenue—200 does
per hour, as shown by point a. As shown by point b on the demand curve, the price required to sell this
quantity is $18 per dose.
(B) The long-run supply curve of a perfectly competitive, constant-cost industry intersects the demand curve at
point c. The equilibrium price is $8, and the equilibrium quantity is 400 doses.
10.2 THE SOCIAL COST OF MONOPOLY

Deadweight Loss from Monopoly
 FIGURE 10.4
The Deadweight Loss from a Monopoly
A switch from perfect competition to monopoly
increases the price from $8 to $18 and decreases the
quantity sold from 400 to 200 doses.
Consumer surplus decreases by an amount shown
by the areas B and D, while profit increases by the
amount shown by rectangle B. The net loss to society
is shown by triangle D, the deadweight loss from
monopoly.
The formula for the area of a rectangle is
area of rectangle = base × height
The formula for the area of a triangle is
area of triangle = 1/2 × base × height
● deadweight loss from monopoly
A measure of the inefficiency from
monopoly; equal to the decrease in the
market surplus.
(cont.)

Rent Seeking: Using Resources to Get Monopoly Power
● rent seeking
The process of using public policy
to gain economic profit.
Given the social costs of monopoly, the government uses a number of
policies to intervene in markets dominated by a single firm or likely to
become a monopoly.
Monopoly and Public Policy
(cont.)

• A developer interested in building a casino in Creswell, Oregon, placed
a curious announcement in the local newspaper. If local voters
approved the casino, the developer promised to give citizens a total of
$2 million per year.
• With an adult population of about 1,600, each adult in Creswell would
receive a cash payment of $1,250 per year. Why did the developers
propose this deal?
• This is an example of rent seeking: The casino developer was seeking
the profits that would come from having a monopoly in the casino
market, and was willing to pay at least $2 million to get it.
A CASINO MONOPOLY IN CRESWELL OREGON?
APPLYING THE CONCEPTS #2: What is the value
of a monopoly?

Incentives for Innovation
Let’s use the arthritis drug to show why a patent encourages innovation. Suppose a
firm called Flexjoint hasn’t yet developed the drug but believes the potential benefits
and costs of doing so are as follows:
• The economic cost of research and development will be $14 million, including all
the opportunity costs of the project.
• The estimated annual economic profit from a monopoly will be $2 million (in
today’s dollars).
• Flexjoint’s competitors will need three years to develop and produce their own
versions of the drug, so if Flexjoint isn’t protected by a patent, its monopoly will
last only three years.
Based on these numbers, Flexjoint won’t develop the drug unless the firm receives a
patent that lasts at least 7 years. That’s the length of time the firm needs to recover
the research and development costs of $14 million ($2 million per year times 7 years).
If there is no patent and the firm loses its monopoly in 3 years, it will earn a profit of $6
million, which is less than the cost of research and development. In comparison, with
a 20-year patent the firm will earn $40 million, which is more than enough to recover
its $14 million cost.
10.3 PATENTS AND MONOPOLY
POWER

• It is sensible for a government to grant a patent for a product that
would otherwise not be developed, but it is not sensible for other
products.
• Unfortunately, no one knows in advance whether a particular
product would be developed without a patent, so the government
can’t be selective in granting patents.
• In some cases, patents lead to new products, while in other cases
they merely prolong monopoly power.
Trade-Offs from Patents
10.3 PATENTS AND MONOPOLY
POWER (cont.)

When the patent for a brand-name drug expires, other firms introduce generic
versions of the drug. The generics are virtually identical to the original branded
drug, but they sell at a much lower price. The producers of branded drugs have
an incentive to delay the introduction of generic drugs and sometimes use
illegal means to do so.
• In recent years, the Federal Trade Commission (FTC) has investigated allegations that
the makers of branded drugs made deals with generic suppliers to keep generics off the
market.
• Alleged practices included cash payments and exclusive licenses for new versions of the
branded drug.
• In 2003, the FTC ruled that two drug makers had entered into an illegal agreement when
Schering-Plough paid Upsher-Smith Laboratories $60 million to delay the introduction of
a low-price alternative to its prescription drug K- Dur 20, which is used to treat people
with low potassium.
• Another tactic is to claim that generics are not as good as the branded drug. Because
generic versions are virtually identical to the branded drugs, such claims are not based
on science.
BRIBING THE MAKERS OF GENERIC DRUGS
APPLYING THE CONCEPTS #3: What happens
when a patent expires and a monopoly ends?

● price discrimination
The practice of selling a good at
different prices to different consumers.
Although price discrimination is widespread, it is not always
possible. A firm has an opportunity for price discrimination if
three conditions are met:
1 Market power.
2 Different consumer groups.
3 Resale is not possible.
10.4 PRICE DISCRIMINATION

Senior Discounts in Restaurants
 FIGURE 10.5
The Marginal Principle and Price Discrimination
To engage in price discrimination, the firm divides potential customers into two groups and applies the
marginal principle twice—once for each group.
Using the marginal principle, the profit-maximizing prices are $3 for seniors (point b) and $6 for
nonseniors (point d ).
10.4 PRICE DISCRIMINATION (cont.)

Price Discrimination and the Elasticity of Demand
• We can use the concept of price elasticity of demand to
explain why price discrimination increases the restaurant’s
profit.
• From the chapter on elasticity, we know that when demand
is elastic (Ed > 1), there is a negative relationship between
price and total revenue: When the price decreases, total
revenue (price times quantity sold) increases because the
percentage increase in the quantity demanded exceeds the
percentage decrease in price.

Examples: Movie Admission versus Popcorn, and Hardback
versus Paperback Books
• Why do senior citizens pay less than everyone else for admission to a movie, but the same
as everyone else for popcorn? As we’ve seen, a senior discount is not an act of generosity
by a firm, but an act of profit maximization. Senior citizens are typically willing to pay less
than other citizens for movies, so a theater divides its consumers into two groups—seniors
and others—and offers a discount to seniors. This price discrimination in favor of senior
citizens increases the theater’s profit.
• Why are hardback books so much more expensive than paperback books? Most books are
published in two forms—hardback and paperback. Although the cost of producing a
hardback book is only about 20 percent higher than producing a paperback, the hardback
price is typically three times the paperback price. Booksellers use hardbacks and
paperbacks to distinguish between two types of consumers: those who are willing to pay a
lot and those who are willing to pay a little.
• The pricing of hardback and paperback books is another example of price discrimination,
under which consumers with less elastic demand pay a higher price.

• That $4 bucket of popcorn you get in the movie theater costs less than $0.10 to produce.
What explains the 4,000 percent markup?
• Moviegoers vary in their willingness to pay for seeing a movie, and a movie theater has an
incentive to identify the high demanders and charge them more, while keeping the price low
for the low demanders. A reliable predictor of the willingness to pay for a movie is the
consumption of movie popcorn: The people who buy a lot of popcorn are the consumers who
are willing to pay the most for a movie experience. So a convenient way for the theater to
charge more to the consumers who are willing to pay more is to jack up the price of popcorn.
As a result, the low demanders simply pay the admission price, while the high demanders pay
the admission price plus the jacked-up price of a bucket of popcorn.
• We can illustrate with a simple example. Suppose a low demander is willing to pay $11 for a
movie, while a high demander is willing to pay $15 for a movie and popcorn. If the theater
charges $10 for admission and $4 for popcorn, each consumer will get a consumer surplus of
$1 (equal to $11 – $10 for the low demander and $15 – $14 for the high demander), so both
consumers will see the movie. If instead the theater charged $12 for admission and $0.10 for
popcorn, the high demander will see the movie, but the low demander won’t.
WHY DOES MOVIE POPCORN COST SO MUCH?
APPLYING THE CONCEPTS #4: When do firms have an
opportunity to charge different prices to different consumers?

barrier to entry
deadweight loss from monopoly
market power
monopoly
natural monopoly
network externalities
patent
price discrimination
rent seeking
K E Y T E R M S

Econ 204 week 9 outline

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Econ 204 week 9 outline